Ever since the inception of the single currency the monetary policy framework of the ECB has stressed the importance of monetary aggregates. The focus on monetary aggregates is based on the generally accepted view that, in the long term, “inflation is a monetary phenomenon”, meaning that in the medium- to long-term growth in the money aggregates is associated with a rise in the general price level. In the wake of the financial crisis the role of growth in aggregate money as a factor determining financial stability has been stressed more prominently on a global scale, although it was the subject of debate even earlier (see CEPR 1998).
Against this background, in a recent paper (Setzer et al. 2010) we focus on the heterogeneity of monetary aggregates across Eurozone countries and its possible sources, including divergences in house prices. We start from the observation that since the introduction of the euro monetary aggregates have indeed behaved very differently across Eurozone countries. For example, in Spain and Ireland the money stock (M3) grew on average per year by over 11% and 16%, respectively, as compared to 6.5% in Germany.1 Meanwhile differences in house price growth across Eurozone countries were also pronounced and seem to be correlated with the growth of the broad monetary aggregate M3 (see Figure 1). For example, in Spain and Ireland house prices grew at two-digit rates whereas in Germany house prices declined.
Figure 1. House prices and money in the Eurozone
Note: Average annual growth from 1999 to 2008 in %. Money refers to national contributions to euro area M3. Source: ECB and OECD.
The possible theoretical relationships between housing and money demand are multiple.
- First, there may be a wealth effect: after a house price increase households feel richer and want to hold some of that extra wealth in the form of liquid assets.
- Second, there may be a substitution effect: in the face of an expected increase in house prices households see housing as an investment opportunity and are induced to cut their money holdings to fund a bigger or a second home.
- A further relationship between housing and money demand stems from the collateral effect: higher house prices make it easier for households to take out loans. The creation of a new loan is likely to go along with the creation of new deposits and thus increases money holdings.
- Finally, there is a transaction effect: in a housing boom transactions soar and the associated demand for money will increase as well.
Since we treat housing as an asset, the focus of our econometric work is on money (an alternative asset) rather than on credit (a liability), although the two are clearly linked. The estimates based on pooled regressions (using dynamic ordinary least squares) for the Eurozone countries (last two columns of the table below) suggest that higher house prices do raise money demand. In about half of the Eurozone countries in the sample, this effect explains at least one-third of the deviation in money growth from the Eurozone average. There is also evidence that future (expected) increases in house prices reduce the demand for money. Moreover, institutional differences regarding housing and mortgage markets between countries appear to be important determinants of cross-country differences in money demand as gauged by the country-fixed effects. For example, the typical “loan-to-value” ratio differs widely across countries. The higher these are, the stronger will be the demand for money. There is also a positive impact of home ownership on the demand for money.
Figure 2. Determinants of real M3 in Eurozone countries – pooled regression estimates
Did the creation of the single currency impact on the relationship between house prices and the money stock? Interestingly, we find no impact of house prices on money demand prior to monetary union, but it is strongly significant afterwards (see Figure 2). We explain this as follows. The creation of the single currency in Europe created a large pool of liquidity from which (peripheral) Eurozone member states could easily tap, not least since the exchange-rate risk disappeared. Banks in the Eurozone were connected to this pool and got access to cheap wholesale funding – a sea change relative to the situation before the creation of the euro especially in the peripheral countries. Domestic housing booms attracted cross-border capital inflows to a larger extent than before. This is also documented in research on current accounts: Divergence of current accounts is found to be driven by diverging housing market developments and the responsiveness of current accounts to these developments has increased with EMU (European Commission 2009, 2010, Balázs and Kierzenkowski 2010, Giavazzi 2010). The capital inflows were reflected in higher money growth, and we indeed find the heterogeneous developments in money demand to be related to housing.
The results suggest that it is important to monitor money growth at the national level even in the Eurozone. This is particularly relevant since aggregate developments may have been masking diverging trends at the country level, which did eventually have systemic financial stability implications for the Eurozone as a whole. The presence of housing bubbles added to the Eurozone's vulnerability to the crisis, and the rapid money growth in some member countries could have served as an early warning, along with tendencies of rapid credit growth.
Disclaimer: The views expressed in this column represent those of the authors and not necessarily their employers.
Balázs E and R Kierzenkowski (2010), “Exports and property prices in France: are they connected?”, OECD Economics Department Working Papers, 759
CEPR (1998), Asset Prices and Monetary Policy, Mark Gertler, Marvin Goodfriend, Otmar Issing, and Luigi Spaventa, 21 August.
European Commission (2009), “Quarterly Report on the Euro Area, Special report: competitiveness developments within the euro area”, vol. 8(1), March.
European Commission (2010), “Quarterly Report on the Euro Area, Special issue: the impact of the global crisis on competitiveness and current account divergences in the euro area”, vol. 9(1), March.
Giavazzi, Francesco (2010), “Germany’s trade surplus and investments in southern Europe”, VoxEU.org, 21 April.
Setzer, R, P van den Noord and GB Wolff (2010), “Heterogeneity in money holdings across euro area countries: the housing channel”, European Economy - Economic Papers 407, European Commission, February.
1 Data refer to national contributions to euro area M3 and thus exclude currency in circulation.